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Finance Bill 2002: EXPLANATORY NOTE

CLAUSE 82 AND SCHEDULES 26, 27 & 28: DERIVATIVE CONTRACTS

SUMMARY

1. The clause and the 3 Schedules set out a complete new code for the taxation of derivative contracts. They extend the scope of contracts falling within the charge to tax as income along the lines of the draft clauses published in the 19 December 2001 Technical Note. They also rewrite many of the provisions of Chapter 2 Part 4 Finance Act 1994 (financial instruments) so as to be much closer in style and language to the loan relationships legislation in Chapter 2 Part 4 FA 1996.

2. The Schedule is renamed ?Derivative contracts?. This is more informative than the name of the provisions it replaces. In commercial usage, the term ?financial instruments? can often include much more than the limited range of derivative contracts covered in the Chapter. For example, it often includes debt and some equity instruments.

DETAILS OF THE CLAUSE

Clause 82

3. Subsections (1) and (3) provide for the Schedule to have effect, for accounting periods beginning on or after 1 October 2002, subject to the transitional provisions in Schedule 28 - subsection (4).

4. Subsection (2) repeals Chapter 2 Part 4 Finance Act 1994 (sections 147 to 175 and 177 of, and Schedule 18 to, that Act).
Schedule 26

5. The Schedule is divided into 10 parts -

Part 1. Introductory
Part 2. Derivative contracts - the subject matter
Part 3. The method of taxation
Part 4. Accounting methods
Part 5. Special provisions for bad debt etc
Part 6. Anti-avoidance and related provisions
Part 7. Collective investment schemes
Part 8. Insurance and mutual traders
Part 9. Miscellaneous
Part 10. Interpretation
Part 1: Introductory

6. Paragraph 1(1) states the basic proposition that profits from derivative contracts are taxable as income. The paragraph is based on section 80(1) FA 1996.

7. Paragraph 1(2) gives the rule, based on section 80(5) FA 1996, that the Schedule has priority over other legislation where derivative contracts to which the Schedule applies are concerned. This is subject to any rule to the contrary, such as that in section 101 FA 1996 which gives loan relationships priority over derivative contracts. Other provisions overridden by this sub-paragraph include TCGA 1992 (in its application to the taxation of chargeable gains by companies) and section 128 ICTA 1988.

Part 2: Derivative contracts

8. This part sets out the types of contract which are derivative contracts for the purposes of the Schedule.

9. Paragraph 2 establishes what type of contract is capable of being a derivative contract for the purposes of the Schedule. This type of contract is a ?relevant contract?. It is defined simply as any contract which is an option, a future or a contract for differences (CfD).

10. The terms option, future and contract for differences are intended to cover all types of derivative contract. The definitions follow those used in the Financial Services and Markets Act (FSMA) 2000 (Regulated Activities) Order SI 2001/544 (RAO) at Articles 83 to 85 (which replaced paragraphs 7 to 9 Schedule 1 Financial Services Act 1986 on 1 December 2001).

11. However, they do not follow the exact definitions of these terms for FSMA purposes. For example, warrants are not options for the purposes of FSMA , but for the derivative contract rules options include warrants (Paragraph 12(8)). The qualifications in the RAO dividing futures into ones held for investment and for commercial purposes are irrelevant for tax purposes.

12. As a result, the scope of options, futures and CfDs is potentially very wide. The definition of future in paragraph 12(6) for example would cover any purchase or sale contract that is not completed on the same day as the contract is agreed. An option covers any option over any matter. A CfD is not limited as to the property or other matter whose value it reflects.

13. The legislation is intended to have a narrower focus. Its scope is therefore cut down in two main ways - by the accounting tests in paragraph 3 and the underlying subject matter (USM) test in paragraph 4

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14. Paragraph 3 sets out a major limitation to the width of paragraph 2.

15. To be a derivative contract for the purposes of the Schedule, a contract must pass one of the three tests in this paragraph. The first and second are ?accounting? tests. The first, and main test, in paragraph 3(1)(a) is that it is a contract which is treated for accounting purposes as a ?derivative financial instrument?.

16. The second test, in paragraph 3(1)(b), is that it is a contract which is treated for accounting purposes as a ?derivative financial asset?. This test is only relevant for the purposes of paragraphs 6 or 7 (contracts producing a guaranteed return or with a guaranteed amount). This is because the type of contract to which these paragraphs apply is either a prepaid contract which has characteristics of a deposit or is a synthetic deposit derived from a number of interconnected contracts.

17. Paragraphs 3(3) and 3(4) define what is meant by ?for accounting purposes?. It means that it is treated in the company's accounts as a derivative financial instrument or derivative financial asset in accordance with the relevant accounting standard, if it is used, or it would be so treated if that standard applied to the company.

18. Paragraph 3(5) provides that the relevant accounting standard is FRS 13, the current accounting standard in the United Kingdom relating to disclosure of financial transactions. The standard outlines some of the derivative financial instruments to which it applies as follows:

Derivative financial instrument:-

A financial instrument that derives its value from the price or rate of some underlying item.

Underlying items include equities, bonds, commodities, interest rates, exchange rates and stock market and other indices.

Derivative financial instruments include futures, options, forward contracts, interest rate and currency swaps, interest rate caps, collars and floors, forward interest rate agreements, commitments to purchase shares or bonds, note issuance facilities and letters of credit.

19. FRS 13 may not apply directly for a number of reasons. It does not apply to insurance business, and it will not apply in the accounts of a company from a country where UK generally accepted accounting practice (GAAP) and accounting standards do not apply. In such a case the hypothetical treatment under FRS 13 must be established.

20. Paragraph 3(5)(b) provides that a replacement accounting standard is to be used for periods for which it applies. It is expected that by 2005 International Accounting Standards will apply to some or all UK companies, and that IAS 39 (a measurement rather than a disclosure standard) will apply in the UK, amended from its current form as a result of the IASB's improvement project.

21. Apart from the two accounting tests, there is a further one because certain contracts which it is appropriate to include in the derivative contracts regime are not within, or not clearly within, the FRS 13 definitions.

22. The third test, in paragraph 3(2)(a), ensures that all commodity contracts are within the Schedule. FRS 13 draws a distinction between contracts where it is intended delivery should take place and those contracts where it is not so intended. Intention is not an easy criterion for a tax system, so the legislation draws no distinction. The inclusion of commodity contracts settled by delivery is unlikely to make much difference in practice. The vast majority of such contracts would be entered into by traders, and the tax treatment under this Schedule is little different from the tax treatment under the ordinary rules of Case I of Schedule D, especially now that in most cases a company will simply follow its accounts in arriving at its profits for tax purposes - even if it uses a mark to market basis of accounting - see Explanatory Note on clause 63 and Schedule 22.

23. Paragraph 3(2)(b) is for the avoidance of doubt. It ensures that CfDs whose underlying subject matter is intangible fixed assets, weather conditions or which are ?credit derivatives? are included.

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24. Paragraph 4 gives the underlying subject matter (USM) exclusions.

25. All the exclusions apply either where the underlying subject matter consists wholly of only one of these categories, or where it consists of two or more, if they are all within the exclusions (paragraph 4(1)). Thus where a derivative contract has say both shares and an interest rate as its underlying subject matters (as in an equity swap), the contract is not excluded.

26. Paragraph 4(2) sets out the exclusions. There are three ?absolute? exclusions, where the subject matter is

  • Land - paragraph 4(2)(a). This does not include crops minerals etc in or on land.
  • Tangible movable property (chattels) - paragraph 4(2)(b). This includes plant & machinery (from oil rigs to paper clips), but excludes any commodities which are tangible assets. This does not imply that all commodities are tangible - electricity for example is a commodity.
  • Intangible assets - paragraph 4(2)(c). This covers those assets falling within the scope of Schedule 29 the legislation on intangible fixed assets and goodwill (see paragraph 12(11)).

27. There are also three ?qualified? exclusions.

  • Shares - paragraph 4(2)(d).
  • The rights of a unit holder in a unit trust scheme - paragraph 4(2)(e). This covers both authorised unit trusts and unauthorised ones, including overseas ones. It will not cover those unit trusts to which paragraph 4 Schedule 10 FA 1996 applies (bond trusts). Interests in open-ended investment companies (OEICs) are shares within paragraph 4(2)(d).
  • Assets representing loan relationships to which sections 92 or 93 FA 1996 applies - paragraph 4(2)(f). These are convertible or asset-linked securities which are treated in part for tax purposes as if they were shares.

28. Paragraph 4(3) is a special rule for CfDs. Here CfDs over intangible fixed assets are within the scope of the derivative contract rules. This is because options and futures over intangible fixed assets fall within the new rules for intangible assets, but CfDs do not. CfDs are therefore included in the derivative contract rules.

29. Paragraph 4(4), together with paragraphs 5(3), 6(10), 7(9), 8(4), 46(5) and 47(7), explains that this paragraph, like the other paragraphs referred to, is subject to the rule in paragraph 9.

30. Paragraph 9 works to disregard subject matter which is subordinate to the major subject matter, or matters, of the contract, or is small in relation to the subject matter of the contract as a whole - see the commentary below on paragraph 9.

31. Paragraph 4(5) signposts the qualifications of the exclusions where the USM is of the share etc type in paragraph 4(2)(d) to (f).

32. Paragraph 5 is the first of the qualifications from paragraph 4 (paragraph 5(1)). Derivatives over shares, unit trust holdings and section 92 or 93 FA 1994 securities held for the purposes of a trade remain within the scope of the Schedule - paragraph 5(2). This will include banking, share dealing and insurance trades.

33. Paragraph 6 is the second of the qualifications from paragraph 4 (paragraph 6(1)). It reproduces the effect of Schedule 5AA ICTA 1988.

34. Paragraph 6(2) sets out the relevant contracts to which the paragraph applies. They are contracts where the underlying subject matter is shares, unit trusts or section 92 and 93 assets - assets of the type set out in paragraph 4(2)(d) to (f).

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35. Paragraph 6(3) sets out the condition that needs to be met for a contract to come within the derivative contracts regime, notwithstanding paragraph 4. The contract must be one which is designed to produce a guaranteed return either by itself or with one or more other contracts (associated transactions - see paragraph 11) with the same type of underlying subject matter, or with one or more loan relationships within section 92, 93 or 93A FA 1996.

36. Paragraph 6(4) defines ?return? as the amounts accruing to the company from a contract, and in the case of a loan relationship, the amount payable on redemption. Paragraph 6(6) provides that a guaranteed return is produced whenever risks from fluctuation in the underlying matter are so eliminated or reduced as to produce a return which is equivalent to interest.

37. Paragraph 6(5) provides that transactions (a contract, by itself or with other contracts and loan relationships) are designed to produce a guaranteed return if it is reasonable to assume from considering the likely effect of the contract, and the circumstances in which it is entered into, or both, that the main, or one of the main, purposes of the contract was to produce a guaranteed return. Where there is more than one contract or there is also an asset representing a loan relationship it is the combined effect of all of them and the circumstances in which all of them are entered into which may be considered.

38. Paragraph 6(7) gives a gloss on what is meant by the elimination or reduction of risks from fluctuation by including any case where the main reason for the choice of underlying matter is that there is no risk that it will fluctuate or if it does it will fluctuate insignificantly. For example, where the contract concerned is a contract to acquire shares, the underlying matter, the shares, would normally be expected to fluctuate in value. But if a company has (say) only invested in debt instruments with a fixed or predictable return, its profits would be virtually constant and predictable and the value of its shares might be stable.

39. Paragraph 6(7) ensures that a contract to acquire such shares will be within the scope of the paragraph. It is irrelevant that a contract or asset may have been capable in the past of producing a fluctuating return, if by the time it is acquired the prospect of such fluctuation has been eliminated or reduced. For example, a loan may have been issued on terms that it is convertible at an attractive price, such that conversion was likely. If the bond goes seriously ?out of the money? because for example the price of the shares into which it is convertible has crashed, it will behave in future like a straightforward fixed interest security.

40. The paragraph is based to a substantial extent on the provisions of paragraphs 2, 3 and 5 of Schedule 5AA.

41. Paragraph 6(8) defines underlying matter, particularly in the case of an asset representing a loan relationship.

42. Paragraph 6(9) defines ?connected? in terms of the revised rules in section 87 and 87A FA 1996.

43. Paragraph 7 is the third of the qualifications from paragraph 4 (paragraph 7(1)): it is similar in some respects to the paragraph 6 (guaranteed return) qualification. By virtue of paragraph 7(2) it also applies where the contract is one whose underlying subject matter is shares, unit trusts or section 92 and 93 assets.

44. Paragraph 7(3) sets out the condition here which is that the contract is designed to secure that the relevant amount payable does not fall below a guaranteed amount.

45. Paragraphs 7(3)(b) and 7(4) have a similar effect to those of paragraph 6(3)(b) and 6(5). They allow the combined effect of a contract or two or more contracts and/or a section 92 or 93 asset (associated transactions - see paragraph 11) to be looked at and for the main purpose of those contracts to be considered.

46. Paragraph 7(5) sets out that the ?guaranteed amount? is 80% of the consideration paid or payable by the company or a connected company for entering into the various contracts.

47. Paragraph 7(6) defines the ?relevant amount payable? as the amount payable when a derivative contract is performed or an other type of asset is disposed of.

48. Paragraph 7(7) defines ?payment at maturity?. In the case of a derivative it means the payment on performance of the contract, and for a loan relationship, payment on disposal.

49. Paragraph 7(8) defines ?connected? in terms of the revised rules in section 87 and 87A FA 1996.

50. Paragraph 7(10) provides that the paragraph is subject to an election being made under paragraph 48 to split the contract into two parts.

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51. This paragraph is aimed at derivative contracts of a type that have been used by life assurance companies to provide them with the funds to pay benefits under so called guaranteed equity bonds and other similar types of investment policies where the return to the policyholder is linked to (sometimes with an upper limit) an index such as the FTSE 100 but where, if the index falls over the period of the policy, there is a limit to the downside risk to which the policyholder is exposed. Typically such policies promise that the policyholder will get back at least the amount he or she has paid for the policy.

52. Where such assets are structured as loan relationships providing a return linked to an index but with a guaranteed amount they do not fall within the exclusion of section 93 FA 1996 and so the entire return on them falls to be taxed as income. This paragraph ensures that similar treatment is given to derivative contracts having the same effect.

53. Paragraph 8 is the fourth of the qualifications from paragraph 4 (paragraph 8(1)): although paragraph 7 is not limited to contracts held by life assurance companies, paragraph 8 is so limited. It deals with assets backing guaranteed income bonds where because of the structure and the need to provide an amount annually equivalent to a payment of income there may not be a guaranteed return of 80% or more of the initial premiums.

54. Paragraph 8(2)(c) again sets out the type of contract concerned - one whose underlying subject matter is shares, unit trusts or section 92 or 93 assets.

55. Paragraph 8(2) also sets out further conditions which are that the contract is held by a company carrying on long-term insurance business - paragraph 8(2)(a) - and that it is entered into to provide certain benefits - paragraph 8(2)(b).

56. Paragraph 8(3) describes these benefits. They are ones under policies either of life assurance or capital redemption contracts whose terms permit a surrender of part of the benefits conferred by the policy at intervals of one year or less, where the return on the policy equates to a return at interest, because it is expected that a part surrender producing the same amount of ?income? will be made each period. It is by the mechanism of a part-surrender that the ?income? is paid on a guaranteed income bond.

57. Paragraph 9 determines when a relevant contract may be treated as consisting wholly of an excluded subject matter, or a combination of excluded subject matters. It prevents contracts which would otherwise fall outside of the derivatives contract regime being brought in merely because some minor part of their USM is a non-excluded type of property.

58. Paragraph 9(1) sets out the contracts to which the paragraph applies: they are described in sub-paragraphs (2) to (4).

59. Paragraph 9(2) relates to a relevant contract whose USM is any one or more of the excluded types of property specified in paragraph 4(2), plus other non-excluded subject matter; but the non-excluded subject matter must be either subordinate to the remaining USM, or of small value compared with the USM of the contract as a whole.

60. Paragraph 9(3) describes contracts whose USM is one or more of land, chattels (except most commodities), or intangible fixed assets (excluding contracts for differences over intangible fixed assets); and which, as in paragraph 9(2), include non-excluded subject matter which is subordinate or of small value. Paragraph 9(4) repeats this formulation for contracts where the excluded subject matter is shares, rights in a unit trust or convertible or asset-linked securities.

61. This means that any contract whose USM is one or more types of excluded subject matter, plus other matter which is subordinate or of small value, will fall within paragraph 9(2), and may also fall within either paragraph 9(3) or 9(4).

62. It is necessary to make these distinctions because paragraph 6 (contract producing guaranteed return), paragraph 7 (guaranteed amount payable on maturity), paragraph 46 (part of the USM is of an excluded type) and paragraph 47 (USM of different excluded types) all depend on prior exclusion of minor subject matters under paragraph 9; but paragraphs 6 and 7 apply only to contracts whose USM is equity or quasi-equity, while paragraph 47 applies only to a contract which would fall within 9(2) but not within either 9(3) or 9(4).

63. Paragraph 9(5) sets out the rule: for any contract falling with 9(2), (3) or (4), the 'subordinate? or 'small? element of the USM is to be disregarded.

64. Paragraph 9(6) says that the subordinate or small value test is to be carried out when the contract is first entered into or acquired.

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65. Paragraph 10 sets out the meaning of the term ?associated transactions? used in paragraphs 6 and 7. It borrows heavily from paragraph 6, Schedule 5AA where the term is ?related transactions?. Transactions are associated if the are entered into or acquired in pursuance of the same scheme - paragraph 10(1) - whether or not they are entered into with different parties - paragraph 10(2).

66. A scheme or arrangement is the 'same scheme - if the transactions concerned are not independent of each other - paragraph 10(3).

67. Paragraph 10(4) makes it clear that 'scheme? (or ?arrangement?) includes non-contractual arrangements.

68. Paragraph 11 clarifies what is meant by ?underlying subject matter? in Part 2 of the Schedule - paragraph 11(1)).

69. In the case of an option it means the property falling to be delivered on exercise - paragraph 11(2). There is no requirement that the property actually be delivered.

70. In the case of a future it means the property for whose delivery the contract provides - paragraph 11(3). There is no requirement that the property actually be delivered.

71. In the case of a contract for differences, it means the property whose value or price is referred to in the contract or the matter by reference to which any index or factor designated in the contract is determined. For example, a derivative where the amount payable is determined by the change in the FTSE 100 index has shares as its underlying subject matter - paragraph 11(4).

72. Paragraph 11(5) makes it clear that certain matters may be the subject matter of a contract for differences. It specifically includes interest rates (so that common derivatives such as interest rate swaps are clearly included), weather conditions and creditworthiness (thus including all credit derivatives). But weather and credit derivatives that are contracts of insurance are not included - see paragraph 12(5).

73. Paragraph 11(6) is intended to make it clear that the use of interest rates or the time value of money in a formula for determining the amount of a payment when the date of that payment may vary does not make an interest rate the USM of a contract.

74. Paragraph 12 gives definitions for various terms used in Part 2.

75. Paragraph 12(2) defines what is meant by ?capital redemption policy? in terms of section 458 ICTA 1988.

76. Paragraph 12(3) defines contract for differences by adapting the definition in Article 85 of the RAO, and paragraph 12(4) expands on the question of what an index may cover. Index here includes not only what has been termed a ?natural index? such as the FTSE 100, i.e. one created for a purpose independent of the derivative contract which relates to it, but also to indices constructed for the purposes of the contract. For example, a spread bet over cricket scores would be based on an index calculated by the bookmaker - see City Index Ltd v Sadrik (EWHC 21 October 1991 - unreported).

77. Paragraph 12(5) ensures that a number of contracts that might fall to be treated as CfDs using the RAO definition are not so treated for the purposes of the Part and the Schedule. Many of them would in any event be outside on the basis of the accounting test in paragraph 3.

78. In particular an insurance contract is not treated as a contract for differences. The RAO definition is capable of including certain contracts which may also fall to be treated as loan relationships - if they do, they cannot be derivative contracts - paragraph 12(5)(f).

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79. Paragraph 12(6) defines ?future?, which also takes its meaning from the RAO, and paragraph 12(7) includes the gloss on ?price? appearing in Article 84(8) of that Order.

80. Paragraph 12(8) defines an option as including a warrant.

81. Paragraph 12(9) defines warrant to follow Article 79 of the Regulated Activities Order (SI 2001/544). But note that warrants do not include options for the purposes of Article 79 but warrants are specifically included in the definition of options for the purposes of the derivative contract rules (Paragraph 12(8)).

82. Paragraph 12(10) excludes from the definition of futures and options any contract which can only be cash settled. Such contracts, even where called ?options? or ?futures? by the market, fall within the definition of CfD in paragraph 12(3) - paragraph 12(10) ensures that they fall only within that definition. However, a contract which provides for delivery of a foreign currency remains a future or option - the currency in this case is the property that falls to be delivered, not the means of payment.

83. Paragraph 12(12) defines a share as including any share which gives entitlement to distributions.

84. Paragraph 13 gives the Treasury a power to amend paragraphs 2 to 12. This replaces the power in section 177(6) FA 1994 and is designed to ensure that the legislation can take account of developments in markets and the creation of new types of derivatives.

85. It also enables amendments to be made as a result of changes in applicable accounting standards - paragraph 13(4). These changes may be made to have effect for periods current when they are made. This is because the ASB may issue a final standard which comes into force for periods ending after a certain date which may have begun before the standard is issued.

Part 3: Method of Taxation

86. This part gives effect to the proposals in the 26th July 2001 Consultative Document that the core provisions of the financial instrument legislation would be remodelled along the lines of those in the loan relationships rules.

87. Paragraph 14 reproduces for derivative contracts the provisions of section 82 FA 1996 and replaces the rules in section 159 and 160 FA 1994. In relation to non-trading credits and debits the derivative contracts rules are simpler than those for loan relationships because they continue the pattern of section 160 and feed non-trading credits and debits from derivative contracts directly into Chapter 2 Part 4 FA 1996.

88. Paragraph 14(4) provides that an amount which is deductible as an expense of a company's trade by virtue of being a trading debit is not disallowed by any provisions of section 74 ICTA 1988 (allowable deductions in computing trade profits). This rule reinforces the rules in paragraph 1(2).

89. Paragraph 15 reproduces the provisions of section 84 FA 1996 (including the changes made to it by paragraph 4 Schedule 24) again with certain modifications. No reference is made to interest and the description of related transactions is slightly different, as they replace references to redemption with references to the maturity of a derivative contract. The provisions in section 153(3) FA 1994 relating to closing out a contract are not reproduced, but closing out, however it is done, is a related transaction for the purposes of this paragraph.

90. Paragraph 15(3)(b) now deals with forward premiums and discounts in a simple way by making it clear that they are included in the credits and debits to be brought into account - and replacing the new section 153(5) to (13) FA 1994 substituted by clause 69 with effect from 26 July 2001.

91. Paragraph 16 reproduces with modifications the new section 84A FA 1996 which is inserted into Chapter 2 Part 4 of that Act by paragraph 3 of Schedule 23 (assimilation of forex).

92. Sub-paragraph (1) gives the primary rule which is that exchange gains and losses which arise from a company's derivative contracts are included in the profits, gains and losses brought into account generally for the purposes of the Schedule. Arguably exchange gains and losses would be included in the general term, but this sub-paragraph makes the point again clearly to reinforce the change in law. The general rule is subject to the special rules in the rest of the section (sub-paragraph (2)).

93. Subsections (3) to (6) provide for and extend the concept of ?matching? that was previously in the forex legislation, in Schedule 15 and regulations 6 to 12 of the Exchange Gains & Losses (Alternative Method of Calculation of Gain or Loss) Regulations (known colloquially as the Matching regulations). By contrast with the forex matching rules, the new rules are mandatory where the conditions are met.

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94. Under the new matching rules exchange gains and losses fall to be disregarded for the purposes of the Schedule, and paragraph 16(1) in particular, in the period when they arise if:

  • they are exchange gains and losses on a derivative contract which are calculated and taken to reserve
    where
  • they are matched by an equal and opposite exchange loss or gain on any asset

(Paragraph 16(3)(a), (4) and (5)).

95. This is the accounting procedure described in paragraphs 27 to 29 and 51 of the accounting standard SSAP 20. It is a requirement of this section that the offset be made in the same entity accounts - offset in consolidated accounts only is not sufficient.

96. Sub-paragraph (6) overrides the operation of the rule in paragraph 15(3) that amounts taken to reserves are brought into account for the purposes of the Schedule where amounts fall to be disregarded when they are taken to reserves in accordance with sub-paragraphs (4) and (5).

97. Sub-paragraphs (7) and (8) contain a regulation-making power which allows rules to be made to determine when any deferred gains and losses on the derivative contract are brought back into charge. The deferred gains so dealt with include those which were deferred under the previous forex matching rules. They may be brought back into charge as either derivative contracts credits or debits or as chargeable gains or allowable losses under TCGA 1992.

98. A draft of the regulations - The Exchange Gains and Losses (Bringing into Account Gains or Losses) Regulations - has been published by the Inland Revenue, together with Explanatory Notes on them. Note also that paragraph 38 of Schedule 7AC TCGA 1992, inserted by Schedule 8 to the Bill, provides that where a disposal of an asset on or after 1 April 2002 falls to be treated as not giving rise to a chargeable gain as a result of the proposals on substantial shareholdings, any corresponding gains and losses on derivative contracts matched with assets under the Exchange Gains and Losses (Alternative Method of Calculation of Gain or Loss) Regulations SI 1994/3227 will not be brought into account under those regulations.

99. A power in sub-paragraph (3)(b) also allows for variations to the matching rules to meet the circumstances of particular cases.

Part 4: Accounting Methods

100. This part also rewrites a number of the core provisions of Chapter 2 Part 4 FA 1994 to bring them into line with those applying for loan relationships.

101. Paragraph 17 substantially reproduces section 85 FA 1996. It describes what constitutes an authorised accruals basis of accounting and an authorised mark-to-market basis of accounting. It replaces substantially the rules in section 156 FA 1994.

102. Paragraph 17(2) includes the amendment made to section 85(2) FA 1996 which provides that the fact that exchange gains and losses on amounts outstanding at a year end are found by a process of valuation does not mean that an authorised accruals method is not being used.

103. Paragraph 18 largely reproduces the provisions of section 86 FA 1996 and replaces other parts of section 156. It includes a default rule at paragraph 18(4) which was not included in the draft clauses attached to the 19th December 2001 Technical Note to ensure that, if paragraph 18(3) or paragraphs 19 to 21 do not apply, an authorised accruals method must be used.

104. Paragraph 19 contains a rule allowing a non-resident company which would use mark-to-market in relation to certain contracts if it were drawing up its accounts in accordance with UK practice (defined in paragraph 19(5) to mean UK GAAP) to elect to use mark-to-market for those contracts.

105. Paragraph 19(1) gives the case, which is where:

  • a company's statutory accounts are drawn up under ?home state? rules;
  • mark to market (MTM) is not used in those accounts in relation to derivative contracts;
  • MTM would be used if the account were drawn up under UK GAAP.

106. Paragraph 19(2) provides that where the case applies, the company may elect to use MTM if it would use it in UK accounts in accordance with UK practice.

107. Paragraph 19(3) says the election must be made within 2 years of

  • the company's first accounting period to begin on or after 1 October 2001, or
  • the first accounting period in which it is a party to derivative contracts eligible for the election.
    The election then applies to all subsequent accounting periods and is irrevocable.

108. If a company makes the election in relation to its derivative contracts it is also treated as making the equivalent election under new section 86(3A) FA 1996 in relation to its loan relationships - paragraph 19(4).

109. Paragraph 20 supplements paragraph 19. It provides that where a company to which paragraph 19(1) applies uses MTM in its statutory accounts for some or all of its loan relationships, but not for some or all of its derivative contracts - paragraph 20(1) - the company must use MTM for its derivative contracts if it would use it under UK GAAP - paragraph 20(2).

110. Paragraph 21 provides that for contracts falling within paragraphs 6, 7 and 8 (contracts producing a guaranteed return or guaranteed amount) an authorised mark to market basis of accounting must be used.

Part 5: bad debts and similar transactions

111. Paragraph 22 reproduces for derivative contracts paragraph 5 of Schedule 9 FA 1996 and replaces sections 163 and 164 FA 1994. It includes the rules about exchange gains and losses and bad debts that are also included in the loan relationships rules. There is nothing in the derivative contracts rules which reproduces the effect of paragraph 6 Schedule 9 FA 1996 which provides that in most cases no relief is given for bad debts nor for any taxation of releases where the parties are connected.

Part 6: anti-avoidance and related provisions

112. Paragraphs 23 and 24 reproduce for the new Schedule the rule introduced as section 168A FA 1994 with effect from 26th July 2001 by Clause 68. Paragraphs 23 and 24 and section 168A FA 1994 are the derivative contracts equivalent of paragraph 13 Schedule 9 FA 1996 - the unallowable purposes rule.

113. Paragraph 23(1) sets out the case: where a company is party to a derivative contract for an unallowable purpose, the rules of the paragraph apply. Paragraph 24 sets out what is meant by unallowable purpose.

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114. Paragraph 23(2) is the rule for credits. Where credits arising from exchange gains -defined in paragraph 23(9) - are referable on a just and reasonable apportionment to the unallowable purpose, they are disregarded.

115. Paragraph 23(3) is the rule for debits. Where debits are referable on a just and reasonable apportionment to the unallowable purposes, they are disregarded.

116. Paragraph 23(4) to (7) temper the main rules. Paragraph 23(4) establishes the concept of a ?net loss? being the excess of debits disregarded under paragraph 23(3) over the exchange credits disregarded under paragraph 23(2).

117. Under paragraph 23(5) accumulated net losses are capable of being brought into account, i.e. not disregarded, if there are accumulated credits from the same derivative contract for an accounting period.

118. Paragraph 23(6) defines accumulated net losses to mean the net losses that are brought into account in the period in which the net loss arises, or in any earlier accounting period (beginning on or after 1 October 2002), but after deducting the amounts used in an earlier period to enable a net loss in that earlier period to be brought into account.

119. Paragraph 23(7) defines accumulated credits to mean the credits (excluding exchange credits) that are brought into account in the period in which the net loss arises, or in any earlier accounting period (beginning on or after 1 October 2002), but after deducting the amounts used in an earlier period to enable a net loss in that earlier period to be brought into account.

Example 1
In accounting period 1 there are credits in respect of a derivative contract of 1000 which are not disregarded under paragraph 23(2).

In accounting period 2 there are debits in respect of the derivative contract of 5000 and exchange gains of 200. All of the debits and credits are referable to unallowable purposes. There is a net loss of 4800 (5000 - 200)
In accounting period 2, 1000 of the net loss is brought into account (as it matches the taxable credit in accounting period 1). The remainder of the net loss (3800) is disregarded.

Example 2
In accounting period 1 there are debits in respect of the derivative contract of 5000 and exchange gains of 200. All of the debits and credits are referable to unallowable purposes. There is a net loss of 4800 (5000 - 200)

In accounting period 2 there are credits in respect of a derivative contract of 1000 which are not disregarded under paragraph 23(2). 1000 of the net loss brought forward is brought into account in accounting period 2 (as it matches the accumulated credit of 1000 in that accounting period. The remainder of the net loss (3800) is disregarded in both accounting period 1 and accounting period 2, but it may be matched with accumulated credits in accounting period 3 or later.

120. Paragraph 23(8) has the effect that amounts disregarded under this paragraph are not capable of being brought into account in any other way, e.g. as a trade expense under the normal rules of Case 1 of Schedule D.

121. Paragraph 23(10) introduces paragraph 24. That paragraph reproduces the meaning of paragraph 13(2) to (6) of Schedule 9 FA 1996 and defines what is meant by unallowable purpose.

122. Paragraph 24(2) will apply if for example a non-resident company trading in the UK through a branch enters into a derivative contract at or through the UK branch but the derivative contract is used to hedge an asset held by the company at or for the purpose of another branch or its ?head office?.

123. Paragraph 24(3) will prescribe an unallowable purpose to a derivative contract or related transactions where one of the main, or the main, purposes is tax avoidance.

124. Paragraph 25 reproduces paragraph 14 Schedule 9 FA 1996 which was not reflected in Chapter 2 Part 4 FA 1994. Where credits or debits on a derivative contract are capitalised (e.g. interest rate swap payments may be capitalised where interest payments are also capitalised) and the capitalisation is in accordance with UK GAAP, the debits and credits may be brought into account in the period of capitalisation.

125. Paragraph 26 reproduces one part of section 165 FA 1994. That section covered transfers of value in general and also transfers of value where an option which was valuable was left to expire unexercised (abandoned). In both cases the transaction had to be with a connected person. Transactions between connected persons involving derivative contracts are now covered by Schedule 28AA ICTA 1988 (transfer pricing) which is applied to derivative contracts by virtue of paragraph 15 of Schedule 27. Paragraph 26 then remains to deal with abandoned options between connected companies. It has been rewritten so that the question of whether companies are connected is determined by section 87(3) of the FA 1996 (which itself is rewritten to replace the control rules of section 416 ICTA 1988 with those of section 840). The value to be brought into account where the option is not exercised is the amount paid for the option.

126. Paragraph 27 reproduces the effect of section 137 FA 1993 (exchange differences on currency contracts). Instead of ring-fencing losses on such contracts, it disregards both gains and losses to the extent that Schedule 28AA (transfer pricing) operates on the contract.

127. Paragraph 27(1) applies to derivative contracts where in an accounting period Schedule 28AA ICTA 1988 (transfer pricing) applies as if the derivative contract had not been made.

128. Paragraph 27(2) then says that any exchange gains and losses arising in that period on the contract are disregarded - Schedule 28AA does not apply to exchange gains and losses.

129. Paragraph 27(3) does a similar job where Schedule 28AA applies to only part of the derivative contract because at arm's length the terms (including the amounts of any payments) would have been different. In such case paragraph 27(4) provides that only the ?adjusted amount? of exchange gains and losses are to be brought into account under the Schedule. Paragraph 27(5) says what ?adjusted amount? means: it is the exchange gains or losses which would have arisen if the contract had been agreed on arm's length terms.

130. Paragraph 28 contains the derivative contracts equivalent of paragraph 12(1), (2), (6) (8) and (9) (part) Schedule 9 FA 1996 (group neutrality rule). Where a company replaces another company in the same group as party to a derivative contract, the transfer is ignored, except to determine in which company's tax computations credits and debits relating to the contract should appear.

131. Paragraph 29 supplements paragraph 28 in relation to certain insurance business transfers and contains the derivative contract equivalent of paragraphs 12(3) to (5) and part of (9) Schedule 9 FA 1996.

132. Paragraph 30 mirrors the rule to be inserted as paragraph 12(2A) Schedule 9 FA 1996 by Schedule 25 that disapplies the paragraph where the transferor uses a mark to market basis of accounting for the asset concerned.

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133. Paragraph 31 largely reproduces section 168 FA 1994 (qualifying contracts under Chapter 2 Part 4 FA 1994 with non-residents). Instead of latching on to section 167 FA 1994 as section 168 did, paragraphs 31(1) and (2) simply provides that where a derivative contract is entered into with, or has as a counterparty, a non-resident, then no relevant debits may be brought into account.

134. Paragraph 31(3) and (4) define relevant debits as the excess of debits over credits, where the debits and credits relate to periodic payments of notional interest under the contract - e.g. payments under an interest rate or currency swap.

135. The exceptions to the operation of the paragraph are the same as they are for section 168, except that clearing houses within the meaning of section 285 FSMA 2000 are now included as excepted payers - paragraph 31(5) and (9).

Part 7: collective investment schemes

136. Paragraphs 32 to 40 contain new rules for dealing with authorised unit trusts (AUTs) and open-ended investment companies (OEICs). They replace the rules in section 154(2) and (2A) FA 1994 which disapplied Chapter 2 Part 4 FA 1994 in respect of AUTs and OEICs.

137. Paragraphs 32(1) (AUTs) and 33(1) (OEICs) provide that capital profits from derivative contracts are not brought into account.
138. Paragraphs 32(2) and 33(2) define capital profits and losses as the profits and losses that are dealt with in the AUT's or OEIC's statement of total return under two of the headings in that return. The statement of total return is the statement included in the AUT's or OEIC's annual report in accordance with the relevant SORP - paragraphs 32(3) and 33(3).

139. Paragraphs 32(4) and 33(4) define what is meant by the relevant SORP, while paragraph 34 allows the Treasury to amend the paragraph to alter the definition of capital profits or losses where there are changes to the SORP.

140. Paragraph 35 provides that, for the purpose of calculating the UK equivalent profit of a distributing offshore fund (paragraph 5 of Schedule 27 ICTA 1988), the corporation tax rules for calculating the derivative contract profits and losses in new paragraphs 32 to 34 are not to apply. Instead, derivative contract profits and losses for this purpose are calculated as if the offshore fund were an unauthorised unit trust.

141. Paragraph 36 reproduces with modifications the provisions of paragraph 4 Schedule 10 FA 1996.

142. Paragraph 36(1) gives the case: it is where a company has a contract (whether an option, future or contract of differences) over a relevant holding, defined in paragraph 36(3) as

  • rights in an authorised unit trust,
  • shares in an OEIC or
  • a relevant interest in an offshore fund (defined in paragraph 36(4)(a)),
    if the holding fails the non-qualifying investment test in paragraph 8 Schedule 10 FA 1996 - paragraph 35(4)(b). That test is failed if, in general terms, the company's holdings of assets that produce interest and similar contracts amount to over 60% of the total holdings.

143. Such a contract is not a derivative contract under the Schedule because the underlying subject matter is excluded matter but for this paragraph.

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144. Paragraph 36(2) applies the Corporation Tax Acts as if the contract were a derivative contract under the Schedule for the accounting period in which the contract is acquired or entered into, and any subsequent periods during which the company remains a party. It must use an authorised MTM method for accounting for the contract.

145. Paragraph 37 set out the rules that apply where a contract which is not within paragraph 36 becomes one, whether that happens as a result of the enactment of this paragraph or otherwise.

146. Where the contract moves from the chargeable gains regime to the derivative contracts regime, it will be accounted for using MTM in the first accounting period to which this Schedule applies. The market value of the contract at the end of the previous accounting period is used as the fair value for the first new accounting period - paragraph 37(4). Paragraph 37(5) provides that a chargeable gain or allowable loss computed by reference to that market value will be deferred and brought into account when the company ceases to be a party to the contract.

147. Paragraph 38 replicates for investment trusts and venture capital trusts the provision inserted into FA 1996 (the new paragraph 1A Schedule 10) by paragraph 37(2) Schedule 25.

148. It provides that any profits and losses on derivative contracts taken to a capital reserve of an investment trust, in accordance with the relevant SORP, are not brought into account as credits or debits for the purposes of this Schedule.

149. Paragraph 38(2)(a) provides likewise for the profits and losses that VCTs take to capital reserve in accordance with the SORP in question, to be disregarded for tax purposes. But, under paragraph 38(2)(b), even where VCTs do not use the SORP, the same disregard applies to those profits and losses that they would have taken to capital reserve had they used the SORP.

150. Paragraph 38(3) defines what is meant by the relevant SORP.

151. Paragraph 39 ensures that the excess of relevant credits over relevant debits from derivative contracts is treated as income from shares and securities for the purpose of determining whether or not a company may be approved as an investment trust under section 842 ICTA 1988.

152. Paragraph 40 ensures that the excess of relevant credits over relevant debits from derivative contracts is treated as income from shares and securities for the purpose of determining whether or not a company may be approved as a VCT under section 842AA ICTA 1988.

Part 8: insurance and mutual business

153. Paragraph 41 reproduces section 169 FA 1994 and is introductory.

154. Paragraph 42 reproduces with modifications paragraph 1 of Schedule 18 to the FA 1994. This in turn provided that Part 1 Schedule 11 FA 1996 (which gives the loan relationships rules applying to insurance business) applies to Chapter 2 Part 4 FA 1994 and financial instruments within it in the same way that it applies to loan relationships, but with modifications.

155. Paragraph 42(2) makes it clear that it is those parts of Schedule 11 FA 1996 which apply only to debtor relationships that are not applied for the purposes and in relation to derivative contracts. This means that paragraph 2(2) Schedule 11 FA 1996 (treatment of debtor loan relationships in a computation made in accordance with Case 1 rules) does not apply, so that section 83 FA 1989 applies where the profits or losses from derivative contracts are recognised as investment return in the revenue account (Form 40) in a company's regulatory return to the FSA, and the general rules of Case 1 apply where the profits or losses appear elsewhere in that return (e.g. in interest or expenses).

156. Paragraph 42(3) makes the necessary modifications to Schedule 11 FA 1996. In particular:

  • paragraph 1(2)(a) of that Schedule is modified so that it refers to paragraph 14(2) of this Schedule (trading credits and debits); and
  • paragraph 1(2)(a) and (b), 2(1), 2(3), 2(5) and 3(b) are modified so the references in that Schedule there to credits and debits are to credits and debits from derivative contracts given by this Schedule.

157. The fact that paragraph 3(a) Schedule 11 FA 1996 refers only to creditor relationships does not affect the operation of that paragraph in respect of all derivative contracts, whether regarded as assets or not of the company's long-term insurance fund.

157A. Paragraph 42(4) ensures that where an equity derivative is treated as within the derivative contracts Schedule because it is held for the purposes of a trade of life insurance, Schedule 11 FA 1996 does not apply to bring any credits or debits into account for the purposes of that Schedule as it is applied by virtue of paragraph 42. This ensures that where the contract is referable to basic life assurance and general annuity business, the chargeable gains apply, and where it is referable to any other categories of business, section 83FA 1989 applies.

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158. Paragraph 43 deals with the effect of the qualification in paragraph 5 of the exclusion from the Schedule for certain derivative contracts relating to shares etc. The paragraph ensures that where derivative contracts over shares etc. are held wholly or partly for the purposes of life assurance - paragraph 43(1) - then paragraph 43(2) provides that:

  • section 83 FA 1989 will apply where the contract is held for the purposes of those categories of business where a Case VI computation is made and where a Case I computation is made in relation to life assurance business as a whole; and
  • the capital gains rules will apply where the contract produces credits and debits referable to basic life assurance and general annuity business.

159. Paragraph 43(3) makes it clear that for any part referable to long-term business other than life assurance, such as PHI, the trading rules in paragraph 14 apply.

Part 9: miscellaneous provisions

160. Paragraph 44 deals with the transfer of derivative contracts from trade use to non-trade use. The company is treated as disposing of the contract for its fair value. Where it comes into the scope of TCGA 1992 as a result of the appropriation, section 161(2) TCGA will operate and treat it as having been acquired for the fair value given by the paragraph.

161. Paragraph 45 deals with the converse case, where an asset which is not a derivative contract because it is not held for the purposes of a trade becomes one. In this case section 161(1) TCGA 1992 will apply, but the paragraph precludes an election under section 161(3), as that is inconsistent with the way the Schedule brings profits and losses into account.

162. Paragraph 46 allows certain contracts to be split into two. The paragraph is ancillary to paragraphs 4 and 9.

163. Paragraph 46(1) sets out the scope. It applies only to a future or option, not to a CfD. Cash settled contracts cannot be ?futures? or ?options?, by virtue of paragraph 12(10). Futures and options which provide for property to be delivered are, by their nature, simpler instruments capable of being more easily divided up than complex swap arrangements of the type encompassed by CfDs. The contract has to be one that passes the accounting test in paragraph 3, and meets the condition in paragraph 46(2). That requires that the contract's USM consists of one or more of the types of property falling within paragraph 4(2)(a) to (f) and also any type of non-excluded property, e.g. debt.

164. Sub-paragraphs 46(3) and (4) give the rules. A contract falling within the paragraph is split between the two types of USM, using a just and reasonable apportionment.

165. Where the USM includes excluded items within paragraph 4(2)(a) to (f), and non-excluded items, if the latter items are treated as subordinate or small within the meaning of paragraph 9, then the contract will be excluded from this paragraph - paragraph 46 (5). The 'small? or 'subordinate? items are disregarded, not treated as the subject matter of a separate contract.

166. Paragraph 47 similarly allows a future or option to be split into two where its subject matter is a mix of different excluded types of property. The paragraph applies to a contract which has as its USM both property within paragraph 4(2)(a) to (c) (land, chattels which are not commodities or intangible assets), and property within paragraph 4(2)(d) to (f) - that is to say, shares and things equivalent to shares. This is set out in paragraph 47(2). Paragraph 47(7) makes it clear that if, once small subordinate items have been disregarded under paragraph 9, the USM does not fulfil this condition, then the contract does not fall within paragraph 47.

167. Paragraph 47(3) provides that, for the purposes of corporation tax (including corporation tax on chargeable gains), the contract is treated as if it were two notional contracts, one whose USM consists of the matters within paragraph 4(2)(a) to (c), and one whose USM consists of those within paragraph 4(2)(d) to (f). In making the split, just and reasonable apportionments of value can be made - paragraph 47(4).

168. Paragraph 48 allows a company which is party to a contract to which paragraph 7 applies (a contract producing a guaranteed amount on maturity) - paragraph 48(1) - to make an election to treat the contract as consisting of two separate contracts. Paragraph 48(2) says that the two contracts will be treated as:

  • a creditor loan relationship of the company which is a relevant zero coupon bond (ZCB); and
  • an option over the underlying subject matter of the paragraph 7 contract (usually shares).

169. Paragraph 48(3) provides that a relevant ZCB is one which is issued when the paragraph 7 contract is entered into, is redeemable when the guaranteed amount is payable and has an issue price which is discounted at a market rate from the amount payable on maturity. It is treated as not paying any interest for the purposes of the discount calculation - paragraph 48(8)(b).

170. The ZCB must be accounted for on a MTM basis - paragraph 48(4).

171. The option is treated as being outside the Schedule, as none of paragraphs 6 to 8 apply - paragraph 48(5).

172. The contract is divided on a just and reasonable basis - paragraph 48(6).

173. The election must be made within 2 years of end of the first accounting period in which the company is party to the contract, and has effect for all subsequent accounting periods and is irrevocable - paragraph 48(7).

174. Paragraph 49 deals with partnerships and follows the provisions of paragraph 19 Schedule 9 FA 1996 inserted by paragraph 31 Schedule 24.

175. Paragraph 49(1) sets out the case. It applies where a trade or business is carried on by persons in partnerships (called a ?firm?) and a derivative contract is entered into by the firm.

176. Paragraph 49(3) provides that each company partner is to bring credits and debits into account separately, and that the rules of section 114 ICTA 1988 for a comprehensive computation of a deemed company are not to apply to such credits and debits - paragraph 49(2).

177. Paragraph 49(4) and (5) provides that each company partner is treated effectively as having a separate derivative contract, and only brings into account a part of the total (?gross?) credits and debits of the firm based on its profit share - paragraph 49(6).

178. Paragraph 50 explains what accounting method is to be used where - paragraph 50(1) - a company is a partner and the partnership has a derivative contract to which paragraph 49 applies.

179. Paragraph 50(2) provides that paragraph 18 (authorised accounting methods to be used) applies subject to the override of paragraph 50 (3) - where the company does not account for the assets of the firm separately in its own accounts, but uses MTM to account for its interest in the partnership, it must use MTM for its share of the gross credits and debits from the firm's derivative contract (irrespective of what accounting method is used by the firm).

180. Paragraph 51 deals with the deduction of tax and reproduces section 174 FA 1994. No tax is deductible under section 349 ICTA 1988 in relation to a derivative contract as defined in the Schedule.

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Part 10: interpretation

181. Paragraph 52 defines 'statutory accounts? and reproduces the provisions of section 86(8) FA 1996.

182. Paragraph 53 defines ?relevant contract? and gives the meaning of ?entering into and acquiring a contract? or ?being party to the contract?. This last phrase covers cases where the company has ceased to be a party to the contract but nonetheless brings amounts into account in a later period. The company is to be regarded as still party to the contract in that later period.

183. Paragraph 54(1) defines various terms used in the Schedule.

184. Paragraph 54(2) and (3) defines exchange gains and losses using the same definition as in new section 103(1A) and (1B) FA 1996, inserted by paragraph 7 Schedule 23.

185. Paragraph 54(4) defines financial trader, reproducing the definition in section 177(1) FA 1994 as amended by the Financial Services and Markets Act 2000 (Consequential Amendments) (Taxes) Order 2001 (SI 2001/3629).

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Schedule 27

186. This Schedule makes amendments to other provisions of taxes legislation that are consequential on the changes made by Schedule 26.

187. Paragraph 1 is introductory.

188. Paragraph 2 amends section 15 of the Taxes Act (Schedule A) to update the references to derivative contracts.

189. Paragraph 3 amends section 128 to ensure that for corporation tax purposes a charge under the derivative contracts regime, or where the contract is not within that regime, any capital gains charge, takes priority over any possible charge to tax under Case VI or Case V of Schedule D.

190. Paragraph 4 makes consequential amendments to section 399 (dealings in commodity futures etc: withdrawal of loss relief). Where profits on dealings in certain derivatives are taken out of the Schedule D charge and into the capital gains regime through section 128, section 399(1) prevents losses nevertheless being set against Schedule D profits. Section 399(1) is now applied only to income tax, and a new section 399(1B) makes an equivalent provision for corporation tax: there can be no such double-counting of losses on contracts within either the derivative contracts or capital gains regimes.

191. Paragraph 5 amends section 440 to deal with deemed disposals and re-acquisitions of derivative contracts

192. Paragraph 6 repeals section 468AA (futures and options of unit trusts etc.) which is redundant.

193. Paragraph 7 amends section 468L (interest distributions by unit trusts) as a consequence of paragraph 43 Schedule 26 and paragraph 16 of this Schedule (which amends paragraph 8 Schedule 10 FA 1996)

194. Paragraph 8 amends the reference to FA 1994 (financial instruments) in section 501A (supplementary charge in respect of ring fence trades) to the derivative contracts Schedule.

195. Paragraph 9 amends section 768B (change in ownership of investment company) so that it deals with debits relating to derivative contracts.

196. Paragraph 10 amends section 768C (assets transferred in a group) in similar fashion.

197. Paragraph 11 amends section 798B (double taxation relief: financial expenditure) to update the references to derivative contracts.

198. Paragraph 12 amends section 807A (DTR and loan relationships/derivative contracts) and specifically provides that the types of payment covered are those which arise on notional principal contracts such as interest rate swaps.

199. Paragraph 13 includes a reference to derivative contract as defined in Schedule 26 in the interpretation section 834.

200. Paragraph 14 amends Schedule 5AA. The effect is to remove from it all provisions relating to corporation tax and to ensure that for periods beginning on 1 October 2002 or later the Schedule does not apply for the purposes of corporation tax. This is because paragraph 6 Schedule 26 deals comprehensively with cases where a guaranteed return is produced by derivative contracts.

201. Paragraph 15 amends Schedule 28AA (transfer pricing) so that it now applies to derivative contracts (except in relation to exchange gains and losses - see paragraph 27 Schedule 26.)

202. Paragraph 16 makes consequential amendments to the provisions of section 226 FA 1994 for corporate members of Lloyd's.

203. Paragraphs 17 to 21 amend the Loan Relationships legislation. They change those parts of it which relied on the FA 1994 terminology, or they omit references to that Act.

204. Paragraphs 22 and 23 make consequential amendments to the tonnage tax legislation.

205. Paragraph 24 signals the following amendments to provisions of Finance Act 2002 having effect from an earlier date than this Schedule.

206. Paragraph 25 repeals clause 77 which applies from 26 July 2001. For accounting periods beginning on or after 1 October 2002, it is superseded by paragraph 6 Schedule 26 and the repeal of Schedule 5AA for corporation tax.

207. Paragraph 26 amends a cross-reference in Schedule 29 (taxation of intangible fixed assets), paragraph 75, from ?qualifying contracts within Chapter Part 4 of the Finance Act 1994? to ?derivative contracts (see Part 2 of Schedule 1)?

Schedule 28

207. The Schedule gives the transitional provisions for Schedule 26

208. Paragraph 1 prevents a company from avoiding the effects of the new rules by changing its accounting date. It is based loosely on section 166 FA 1993 which did the same for the transition to the 1993 Forex rules.

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209. Paragraph 1(1) sets out the case - it is where a company has an accounting period (or more than one) for a period shorter than a year which began on or after 1 October 2001 and ends before 30 September 2002 and where the reason for the shortness of the period is that the company changed the date to which it makes up its accounts for the purpose set out in paragraph 1(2). That purpose is one of avoiding amounts being brought into account under the new Schedule that will be increased (if credits) or reduced (if debits) as compared with their treatment under the existing financial instruments regime.

210. Paragraph 1(3) then applies Schedule 26 for the curtailed accounting period. Where a company gave notice, before 19 December 2001, to Companies House of a change of accounting date, it is highly unlikely that the purpose test in paragraph 1(2) would be met. For example, if on 18 December 2001, a company gave notice of a change of accounting date from a year-end of 30 September 2001 to 31 October 2001, it is very unlikely that the purpose would have been to avoid future tax liabilities, in which case the new rule would not apply.

211. Paragraph 2 is the first of a number of transitional rules for companies coming into Schedule 26.

212. It deals with the case where a company was a party to a financial instrument - a qualifying contract under Chapter 2 Part 4 FA 1994 - before the start of its first accounting period to which the Schedule applies (the one first beginning on or after 1 October 2002), but had ceased to be party before that date - paragraph 2(2).

213. If the contract would have been a derivative contract within Schedule 26 had it still been held on that date - paragraph 2(3) - no amounts are required to be brought into account under that Schedule even though profits and losses from the contract may fall to be brought into account for the purposes of that Schedule, so long as they were brought into account under Chapter 2 Part 4 FA 1994 - paragraph 2(3).

214. This might apply if a contract was disposed of but under the relevant accounting method, profits or losses arising from the disposal are permitted to be spread forward by an authorised accounting method.

215. Paragraph 3 deals with the more straightforward case where a qualifying contract was held at the start of the first new accounting period to which the Schedule applies - paragraph 3(1) to (3). The simple rule here is that no amounts may be brought into account twice, and no amounts may be left out of account - paragraph 3(4) and 3(5).

216. Paragraph 4 deals with the transitional provisions into the new regime where the contracts fell within the chargeable gains rules before the commencement day for Schedule 26. When the contract is disposed of, a chargeable gain or allowable loss is brought into account being that which would have accrued, had there been a disposal immediately before commencement day for whatever is the carrying value of the contract at the beginning of the company's first new period.

217. Paragraph 5 applies where a company holds, both before and on its commencement day, a contract which is potentially brought within the derivative contracts regime by paragraph 7 Schedule 26 - paragraph 5(2) and (3). The contract must have been a chargeable asset before the company's commencement day - paragraph 5(4). In these circumstances, the company can make an irrevocable election, within two years of the end of the first accounting period to which the new regime applies, to treat the contract as if it were a zero coupon bond (ZCB) plus an option - paragraphs 5(5) and (6). Sub-paragraphs (7) to (10) set out what happens when a contract, in respect of which a paragraph 5(6) election has been made, is disposed of.

218. Paragraph 6 deals with the transitional provisions into the new regime where the contracts would have produced a Schedule 5AA profit if disposed of before accounting periods beginning on or after 1 October 2002. Under the transitional rules, if the actual disposal would have given rise to a Schedule 5AA profit, that profit is brought into account, after deducting any amounts brought into account under Schedule 26 in relation to the contract.

219. Paragraph 7 defines terms for the purposes of this Schedule.

BACKGROUND

220. The financial instruments legislation was introduced in 1994 to provide certainty for the taxation of what were then known as ?new financial instruments?.

221. The main effect of the financial instruments legislation was to tax as income all profits and losses from derivatives based on interest rates and currencies (and also, with the introduction of the loan relationships rules in 1996, most forms of debt), sweeping away the distinction between capital and revenue. And profits and losses were taxed on an accruals bases, in most cases following the company's accounts drawn up in accordance with UK generally accepted accounting practice (GAAP).

222. The Inland Revenue began a review of the operation of this legislation in 1999 which indicated that the legislation was in broad terms working well but that some points were causing difficulties.

223. This led to a process of public consultation which began with the publication of a Technical Note on 7 November 2000 (?Corporate Debt, Financial Instruments and Foreign Exchange Gains & Losses?). This suggested extending the scope of these rules to cover a wider range of derivatives and aligning the operative provisions with those of loan relationships. And it invited comments on any other aspect of the financial instruments rules where legislative changes or better guidance were needed. There were 28 responses.

224. A Consultative Document (?Corporate Debt, Financial Instruments and Foreign Exchange Gains and Losses?) was published on 26 July 2001. This announced Ministers? decisions in the light of the responses, sought comments on certain issues and contained illustrative draft clauses. There were 46 responses.
225. A further Technical Note (?Loan Relationships, Derivative Contracts and Foreign Exchange Gains and Losses?) was published on 19 December 2001. This invited comments on draft clauses. There were 29 responses.

226. The main issue concerned the scope of the financial instruments legislation. Since the enactment of the financial instruments legislation, the markets have developed new instruments to hedge against a wider variety of risks, such as weather and creditworthiness. Unlike financial instruments, the new derivative contracts legislation covers all derivatives except those which are expressly excluded.

227. The new derivative contracts legislation also contains operative provisions remodelled along the lines of those in the loan relationships legislation. All profits and losses arising to a company from its derivative contracts will be chargeable as income.

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